It’s easy to predict Wall Street. Not the stock market. Wall Street.
Sure, you may have a sense of where the stock market is heading in the next ten seconds or maybe the next ten minutes, if you have access to the right databases and analytics and if you devote your life to watching the index futures-cash spread. The problem is, even if you figure out how to arbitrage the futures and cash indexes, you can’t exploit them. The commissions will eat you alive.
Sure, with a little work you can find stocks whose prices are being goosed into the stratosphere, but you can’t profit from that. The SEC, caving in to a handful of scam artists, loudmouths, and crackpots, recently passed a rule that prevents even the pros from betting against crummy, manipulated stocks. We’ll be delving into that sorry bit of nonsense later in this book.
You can certainly hand over your hard-earned money to one of the thousands of market seers, newsletters, financial publications, and seminars, all aimed at helping you predict the stock market and individual stock prices. However, you stand to gain as much benefit doing that as you would by folding your money into paper boats and sailing them down the Niagara River.
Microcap stocks take that predictability principle to its logical conclusion by offering a guarantee. They are a sure thing. They are always a center of fraud. They were. They are. They always will be. This market’s stoic adherence to the crooked borrows from the Cheyenne, for whom the past, the present, and the future are intertwined into a single, continuous entity. Just as the Native American warriors of old would cry, “It is a good day to die,” you must have the same attitude of stoic acceptance when buying a microcap stock. “It is a good day to be ripped off!” Let that be your battle cry.
Yet while there are plenty of newsletters, analyst reports, unsolicited emails, and Web sites that helpfully assist in the perpetration of microcap fraud, using names such as “The Next Big Winners,” you’d be hard-pressed to find many with names such as “The Next Big Scandal.” That’s because fortunes are made on Wall Street by catering to your greed. Not a penny is to be made protecting you from Wall Street’s greed. That’s your job.
The reason for this is fundamental to Wall Street. You might say that Wall Street is like a cozy blue-collar neighborhood or a small town where people are hospitable, if not exactly friendly, to outsiders. In the eyes of the law, Wall Street is not Dodge City, as it is often portrayed in the media, but rather a tree-shaded side street in Mayberry, one that Opie might have used on the way to the fishing hole.
In Mayberry, the doors are always unlocked. People trust one another. The entire system of Wall Street policing is based upon this kind of small-town neighborliness and confidence—not your confidence in Wall Street, but the confidence that Wall Street has in its regulators, and vice versa.
In this very special world, the New York Stock Exchange is a very special place. If the SEC is the easygoing Andy Taylor in the regulatory Mayberry, the NYSE is the goofy, goggle-eyed Barney Fife. Not the man you’d want to charge into a crack house. But there are no crack houses in Mayberry, only nice people who occasionally get involved in wacky situations.
Mayberry is a self-policing little town, where neighbors watch out for neighbors. Wall Street is self-policing too. Perhaps you have heard the term “self-regulatory organization,” or SRO. That is what the NYSE is supposed to be. Let’s focus on that for a moment. This expression and acronym are used in the media so much that it is easy to be lulled into a sense of numbness. Since the word regulatory is in there, it is widely assumed that something regulatory is actually involved, in the sense of, perhaps, the voltage regulators that used to actually regulate voltage in old Chevys.
If that is what you think, you have made a fundamental mistake. Remember that this is Mayberry, where people trust one another and where there is no real policing going on—just a couple of good old boys with badges.
Organizationally, the SROs and their government overlords are arrayed in a kind of pyramid. At the top is a U.S. government agency, the SEC, along with a few other governmental bodies that oversee the options and commodities markets, banks, and other financial conduits. Below them, on the second tier, are the NYSE, NASD, and various stock markets, and commodities, futures, and options markets. And then we come to the bottom segment. “The most critical element in the self-regulatory system” is what it is called by no less an authority than the standard, lawyer-thumbed text on the subject, Wall Street Polices Itself, by David P. McCaffrey and David W. Hart, published in 1998 by the very distinguished and serious Oxford University Press.
Let’s see if you can guess that all-important third layer of the pyramid from the following four choices:
If you guessed “A,” you made an understandable error, but failed to take the long view. New York attorneys general and nosy state regulators may come—but they invariably go. Besides, acclaimed and praiseworthy as he surely is, for some reason Eliot has rarely used his inherent powers to bring criminal charges against Wall Street transgressors. So he has not left as much of a mark as would seem warranted by the press coverage. During the period we are blessed by their presence, Eliot and other such interlopers are viewed by Wall Street and the pyramid as a recurrent affliction. They are to be tolerated until they lose interest or run for higher office.
“B” is also wrong. The feds are another recurrent disease, albeit a particularly nasty one because—unlike Eliot Spitzer—they can be counted on to toss people in the jug. Rudy Giuliani periodically incarcerated Wall Streeters during the overblown insider-trading scandals of the 1980s. A decade later, the FBI and prosecutors briefly stepped in as de facto regulators when the NASD and the SEC did nothing about rampant criminality among microcap brokerages. As I will be describing later, the microcap market has now shifted back to its accustomed status of being universally ignored.
“C” is a trick answer. Anything quite so straightforward as “no regulation at all” would simply not live up to the deceptiveness required to preserve the status quo while providing the illusion of action. That was the problem, incidentally, with Harvey Pitt, the Wall Street lawyer who took time off from defending Wall Street as a private attorney so that he could defend Wall Street as George W. Bush’s first head of the SEC. Harvey was a very proud, very undisguised Street partisan, who made it plain from the beginning that giving tough speeches and furrowing eyebrows was not for him. An Artie Levitt approach, tough-talking but nonregulating, was not for him. He was going to give nice speeches while doing nothing. That would never do.
The correct answer, “D,” is the one you might have thought was the distracter, to snare those of you who didn’t study for this quiz. Brokerage firms are the first line of defense against excesses committed by brokerage firms. Every brokerage firm, every peddler of stocks and mutual funds and options and futures—you name it—is a little self-regulatory operation of its own. All of them, without exception. Even the tiny outfits that sell microcap stocks, where you might find gangsters toting guns—they are all self-regulatory operations, with “compliance” officers who are supposed to see that brokers who bought their licenses abide by the securities laws.
Just as the Wall Street version of meting out justice can be easily applied to other forms of disputes, this self-regulation concept can also be easily applied to every commercial endeavor. If you are a tenant, the first line of defense against excesses committed by your landlord could be a “housing-law compliance officer” in your landlord’s company. That dumpy restaurant that gave you a dose of food poisoning—well, surely a “compliance chef” in the kitchen would take you to the hospital. If the doctor there cuts off your leg instead of pumping your stomach, the hospital’s “medical compliance” officer would be your protector. And so on and so forth.
If you’re a broker, you can’t cut off a customer’s leg, but you can cheat him. You can break the law. When that happens, the self-regulatory system swings into inaction.
My favorite saga of self-regulation—it’s really nonregulation, but let’s not get hung up on semantics—involves the NYSE. What’s nice about this story is that it is so clear-cut in its murkiness and in the serene flow of its double-talk and hypocrisy, and is laid out in reams upon reams of court papers. It is a tale that more or less concluded in August 2004. It began in a happier era, when we were all so much more prosperous and optimistic.
The year was 1998, and visitors still lined up outside the NYSE building to wait their turn for the gallery elevators. On the floor, brokers were happily trading away. There were the specialists, who had a job that is, as I described, theoretically masochistic. And then there were the floor brokers, who had what has got to be one of the most frustrating jobs in the world.
Imagine a job at a rather shady racetrack in which you work as a courier, and you get to convey the results of the eight daily races before the horses have even left the starting gate. Now, wouldn’t you feel just a bit tempted to put in a bet yourself, or to slip a few bucks to a pal to do that for you and split the winnings? Floor brokers have the job of going to the specialist booths and executing trades, without making a buck for themselves on all that inside info they get just because they work on the exchange floor. They know when big, market-moving orders are about to take place—really hot inside information.
Weakness is part of the human condition. A tiny number of floor brokers succumbed to temptation. A very small and unrepresentative number of brokers did that, the NYSE has long since emphasized, and would probably want me to emphasize, so I have done so.
The shocking news broke on February 25, 1998. “Big Board Floor Brokers Charged in Illegal Profits” said a front-page article the following day in the New York Times. It was big news. Confidences had been violated. Bonds of trust, upon which the entire self-regulatory system depends, had been allegedly tossed away by eight floor brokers. Instead of just carrying out their frustrating jobs, acting as couriers toting orders around the floor, they had actually made a few bucks by trading for their own profit, which they shared with customers. Bad! Wrong! Mary Jo White, the U.S. Attorney for Manhattan, a small woman with cropped hair and a stern and implacable demeanor, was righteously indignant. In a statement, handed out to the press early on February 25, she pointed out:
When Congress passed the Securities Act of 1934 it determined that floor brokers who engaged in proprietary trading on national securities exchanges had a significant—and fundamentally unfair—informational and trading advantage over their customers and other market participants. Congress prohibited proprietary trading by floor brokers because it determined that allowing floor brokers to exploit this advantage would undermine public confidence in the integrity of the securities markets.
That last point justified all the indignation. You’ll read words like “public confidence in the integrity of the securities market” whenever Wall Street does something bad. If members of the public feel that nasty stuff is happening, they may think that Wall Street is just a rigged game and stop buying stocks. Now, that’s actually not a bad idea at all, as we’ve seen. But let’s put that aside and agree with her for the moment, just to be nice.
Mary Jo White did not have the last word on February 25. Dick Grasso, now three years into his term as chairman, assured the public that the NYSE, working with the federal government, had the malefactors cornered like rats:
Our enforcement [and] market surveillance divisions have aggressively worked hand-in-hand with the U.S. Attorney’s office on this investigation. Any activity by a NYSE member or member firm that violates federal securities law or NYSE rules simply will not be tolerated. This has long been paramount as we preserve the integrity of our marketplace.
This is truly an example of what can be accomplished when the federal prosecutor, the federal regulatory authorities and self-regulatory organizations work in cooperation toward a common goal.
Inspiring, isn’t it—all that “aggressively working hand-in-hand”? (They say you can always tell an Assistant U.S. Attorney or NYSE enforcement guy by the scratches on his palms, from all that aggressive hand-in-hand working.) In an interview the following morning on CNBC’s Business Day, an SEC enforcement official named Henry Klehm portrayed the NYSE floor in stark terms—as a kind of Old West open range, where right and wrong stood out in stark contrast to each other in the clean, thin air of the high desert. “These rules are very clear as a matter of the federal securities law and as a matter of the New York Stock Exchange rules,” said Klehm.
The legal process began to churn immediately. Contrary to the prevailing view that the criminal justice system coddles defendants, it is actually a fearsome thing to behold when viewed from the criminal perspective. Guilty pleas began, superseding indictments were handed up, court rulings were issued, and pretty soon the whole thing lumbered heavily out of the public view. Scandals are like that. They begin with a great thunderclap of attention, but then the ponderous machinery of justice takes over. Unlike the swift and fair adjudication that Rand Groves and other brokerage customers encounter when they file claims against brokers, the judicial machinery in criminal cases is ponderous and wordy, producing a great many filings and documents.
The court files bulged, and continued to fatten through 1998 into 1999 and 2000, as the public yawned and stretched and assumed that matters were well in hand. The World Trade Center fell and the court file was still fattening. New scandals arose, nudging aside old, obsolete scandals. The floor-broker cases drifted off the front pages and onto the back pages, and then faded away. As public attention drifted elsewhere, the secrets of the entire Wall Street policing system were being revealed in court files for everyone to see, in the public-records room on the third floor of the new federal courthouse on Pearl Street overlooking Chinatown. While journalists and public officials were scratching their heads trying to figure out what was wrong with Corporate America and Wall Street, anyone could have found out the answers right there at the courthouse—and then gone out for some great dim sum.
The reason all these insights were still there, available for all to see in the public-records room, was that one of the floor brokers wouldn’t cop a plea. Usually, faced with the possibility of a life-ruining prison term under the inflexible sentencing guidelines, defendants in such situations don’t engage in hair-splitting legal circumlocutions. They cut a plea bargain, do their time, and move on. However, a floor broker named John R. D’Alessio wouldn’t play along. He pleaded not guilty and actually had the gall to sue the NYSE.
D’Alessio and his lawyer, a feisty one-man practitioner named Dominic Amorosa, made allegations that were self-serving and seemed wild and hard to swallow, even if they didn’t concern an institution of such formidable reputation as the NYSE. D’Alessio asserted that he was prosecuted, and in the process saw his career go down the toilet, for doing things that were not unambiguously wrong as alleged by Klehm, but were sanctioned and tolerated. D’Alessio’s NYSE was a sleazy, morally ambiguous world, a good deal more David Mamet than John Ford. His NYSE trading floor was so slippery that you’d think they’d have to wear cleats, all nine hundred specialists, traders, clerks, and cable-TV talking heads.
There was some media coverage of all this, as other floor brokers came forward to claim that they were being singled out for punishment for conduct that was tolerated by Grasso and other NYSE managers. I wrote one lengthy piece on D’Alessio et al. in early 1999, and TheStreet.com covered the story doggedly. Still, none of the stories got much traction. Even when the NYSE was put through the ringer in 2003, after which it was under new leadership and supposedly reforming, D’Alessio’s very troubling allegations were completely forgotten. When Fortune lambasted Grasso in a ten-thousand-word profile in October 2004, the magazine didn’t even mention the floor-broker cases at all.
D’Alessio’s allegations didn’t even help D’Alessio all that much. The criminal case against him was dropped by the U.S. Attorney’s office, but apart from that he lost every step of the way. His suit against the exchange was dismissed. His hopeless battle finally came to an end in August 2004. (Or, to be more precise, when his appeal of the federal court ruling dismissing his appeal of the SEC action rejecting his appeal of an NYSE disciplinary action was rejected by the Second Circuit Court of Appeals.)
D’Alessio’s allegations against the exchange would be tossed on the dung heap of history were it not for something that emerges when you look at all those mountains and mountains of court papers: D’Alessio was telling the truth. His case is so well documented that it is hard to come to any other conclusion. The August 2004 appellate court ruling in his case, and a similar case involving other floor brokers represented by Amorosa, paint a troubling picture of the NYSE’s oversight of the trading floor. Indeed, when you read these decisions, you really wonder whether the feds went after the wrong guys in 1998.
That SEC enforcement guy who gave the morning-after interview on CNBC, Henry Klehm, was right, though not in the way that he intended. Klehm and Mary Jo White might believe that the law prevented floor brokers from trading for their own profit. The law may very well have the clarity of a Norman Rockwell painting. But a very different reality existed on the floor of the exchange, in much the same way as real estate salesmen really do have to follow all the niceties of consumer protection laws, but things break down a little when Mitch and Murray are putting on the squeeze and the Glengarry leads are going only to closers.
Just as muffler mechanics had to overcharge customers if they wanted to make a living on Jerome Avenue in the 1970s Bronx, floor brokers had to cut corners as well if they wanted to make a living on Wall Street. You really can’t blame them. They were caught in an inherently illogical, deeply corrupt system of which exchange bosses were perfectly aware. They even had a name for it—it was variously known as “flipping” or “trading for eighths”—and it was the very same kind of trading that resulted in indictments in 1998. Beginning in “at least” 1991, according to a subsequent SEC action, flipping was going on unimpeded on the exchange floor.
D’Alessio alleged, and the exchange denied, that almost half of all floor brokers, 230 of them, were engaged in such trading. The exchange’s denials seem a little pathetic when you go through the court filings. So does Dick Grasso’s statement to the media in February 1998.
It’s hard to believe that the NYSE was doggedly pursuing crooked floor brokers when it was fully aware of what they were doing, and had no problem with it. In fact, on March 4, 1993, the NYSE established an Advisory Committee on Intra-Day Trading Practices, and its mission was to “review, and, as appropriate, make recommendations regarding” all this flipping stuff. The aim was to determine whether such trading “interferes with public participation in the agency-auction market and is a practice that is detrimental to the best interests of the Exchange.” The committee eventually issued a report on these intraday practices and recommended that they be restricted.
Were they restricted? Nope.
They were not only not restricted but—well, they were kinda okay. When he sued the NYSE to overturn its sanctions against him, D’Alessio was able to include some damaging quotes from the already lengthy public record to bolster his version of events. He quoted SEC testimony from Edward Kwalwasser, who was head of the NYSE’s regulatory mechanisms throughout the 1990s. Kwalwasser had been asked if it would have been a violation of the law, back in the 1990s, for a floor broker to share in profits from trading on the floor. His response was that it was okay, as long as the account was not in the broker’s name. Grasso also made that point in his letter to the SEC, quoted at some length in D’Alessio’s lawsuit. Kwalwasser’s SEC testimony later that year was quoted, also at length, in a December 1999 ruling on the floor-broker cases issued by Judge Jed S. Rakoff.
So basically the NYSE’s position in the 1990s was that Mary Jo White was wrong. Title 15, U.S.C. Section 78 (k) (a) (1) was wrong. Title 16, CFR, Section 240.11 (a-1) was wrong. NYSE Rule 352 (c) was wrong. The latter said that floor brokers couldn’t “directly or indirectly take or receive or agree to take or receive a share in the profits” from trading.
What apparently trumped all this black-letter law was a kind of “let boys be boys” attitude among the NYSE leadership. As another NYSE official later told the SEC, the belief among NYSE officials in the 1990s was that floor brokers getting a share of the profits was “appropriate.” “The law? We’re the law!” was the NYSE’s position on floor brokers skimming off profits—until the indictments came down, and then it was bad.
Official verdicts on the NYSE’s sheer gall were almost British in their understatement, as they sought to avoid being publicly nasty with this august institution. After all, you can’t get teed off at a flag-draped institution upon which the investing public’s confidence supposedly hinges. Judge Rakoff, a former criminal defense lawyer, reached into his thesaurus and said that the NYSE’s various excuses for profiteering by floor brokers were “anemic.” Other rulings, by the courts and the SEC, called the NYSE’s “interpretation” of the floor-trading laws “restrictive.” None came out and said in plain English that the NYSE let floor brokers break the law by trading for their own profit, and that its excuses were a crock.
The chairman and CEO of the NYSE when all this was going on, by the way, was none other than the old Bush family friend and subsequent SEC chairman, William H. Donaldson. The buck stopped with him. He knew all about this flipping stuff, if he bothered to read some pieces of paper that flitted across his desk from time to time. As an appellate court ruling observed, Donaldson as NYSE chairman had “received communications related to the practice of ‘flipping.’” Again, a very legalistic and precise way of saying “He knew what in hell was going on.”
Now, there are certainly worse things in the world than floor brokers squeezing out a few bucks the way they did in the early 1990s. The illegal trading on the floor of the exchange was kid stuff compared to the widespread ripoffs in the Nasdaq market at the time, which ranged from price fixing to massive microcrap thievery. So with all that worse stuff to ignore, this being Mayberry, you can bet that Arthur Levitt’s SEC wasn’t going to get all riled up about the town drunk. The bonds of fatherly tolerance and affection just leap off the pages of Administrative Proceeding File No. 3-9925, In the Matter of New York Stock Exchange Inc., by which the SEC gave the NYSE a firm slap on the fanny about a year and a half after the indictments were handed up. In stern, sanctimonious regulator-speak, Artie’s SEC found that “the NYSE, without reasonable justification or excuse, failed to enforce compliance with” the various rules and statutes that are “aimed at preventing independent floor brokers…from exploiting their advantageous position on the NYSE floor for personal gain to the detriment of the investing public.”
You have to admire the SEC’s sense of irony and understatement. Actually the NYSE hadn’t just failed to enforce compliance with the laws. You might construe, from all the legal documents piled up in that courthouse, that the NYSE had given the floor brokers a big thumbs-up, allowing them to do stuff for which a few of them were later indicted.
The bottom line was that the SEC, which as pinnacle of the self-regulatory pyramid is supposed to supervise the NYSE, had failed to enforce compliance by the NYSE in its failure to enforce compliance by the floor brokers. So it was inevitable that the NYSE would get a pass. The SEC wasn’t about to give the exchange a bat on the skull when it might bounce back and bop Artie Levitt on the nose. The NYSE was ordered to design programs and implement systems and file an affidavit after twenty-four months and have an independent committee of its board of directors draft a comprehensive manual and appoint a consultant. You can bet that all those “independent” directors did a great job doing that, just as great a job as they did overseeing Grasso’s compensation.
The NYSE probably could have negotiated this kind of cozy, let’s-all-be-pals agreement if it had used one of the ambulance chasers who advertise on the subway that rumbles down Broad Street, but instead it hired the best Wall Street lawyer it could find. His name was Harvey Pitt, and a short while later he climbed to the top of the self-regulatory pyramid and became head of the SEC until he was laughed out of office.
Even the terminally shame-deprived Levitt, who can spin the most laughable cop-out into an investor victory, found this whole NYSE wrist-slapping episode to be so lame that he didn’t bring himself to mentioning it in Take On the Street. That’s the book in which he says that the NYSE “operates at times more like a country club than a quasi-public utility.” He ought to know. When Artie was SEC chairman, he used to moonlight as the groundskeeper.
So there you have the self-regulatory system in inaction. A few flunkies indicted, a wrist-slap, and the status quo was preserved. You will note that Grasso played his role to the hilt in that statement on the day the indictment came out, in which he did an excellent job of preserving the illusion of regulation. He issued a tough statement that made it seem as if the NYSE were right there at the front of the posse, hunting down crooked floor brokers. In fact, the SEC said in its 1999 wrist-slap of the NYSE that the probe was initiated by federal prosecutors, and that the NYSE “learned of the scheme from [federal prosecutors] in 1997.” The exchange had no choice but to tag along, albeit aggressively and hand in hand.
There is an epilogue to this story of the “where are they now?” variety. We know what happened to Grasso. After he turned the piggy-bank NYSE upside down, he went back home to Locust Valley, applied for food stamps, and hired a flack. Ed Kwalwasser, the chief of regulation, decided to retire in early 2004. He had done a splendid job and would be difficult to replace. It was a touchy business. Since the NYSE is owned by all those people on the trading floor, finding a chief regulator is like hiring a maid who has the job of going through your check stubs whenever she feels like it. Kwalwasser was a real fine old gal—the Wall Street version of Andy Taylor’s Aunt Bee. He’d frown and fuss but everyone knew that his heart was in the right place. You could see the love in everything he did, whether it was figuring out a way to let floor brokers break the law, or seeing to it that all those rules and regulations and surveillance mechanisms kept the New York Stock Exchange frozen in time like Petra. He was more a curator than a regulator, or maid.
When Kwalwasser retired in early 2004, the NYSE embarked on a worldwide hunt for a replacement. A search firm gathered résumés from anyone who had ever so much as read a regulation—that’s how thorough the search was. The résumés were piled knee-deep in a football stadium, teams of highly paid specialists combed through them, and who did they pick of the six billion people who were under consideration? Well, this wide net happened to snare the one person who would make the specialists and floor brokers all warm and cozy. His name was Richard G. Ketchum, and he was president of the NASD when Nasdaq traders were fixing stock prices and systematically screwing investors. At the time the NASD settled Justice Department and SEC charges, it became known that the NASD was aware of Nasdaq price fixing as far back as 1990, but did nothing. Yep, all that was going on while Ketchum was in charge, and he was the guy who fended off Artie Levitt’s SEC and the Justice Department, and told the world that everything the brokers did was okay. He was possibly the only person in creation who could play the role of Aunt Bee as convincingly as Kwalwasser.
Think back to the heartwarming story of Kwalwasser and Ketchum whenever you read that some scandal means Wall Street is going to the woodshed. Doesn’t happen, folks, not in Mayberry. The media, institutional investors, and Congress couldn’t have gotten madder at the NYSE than they did after Grasso bled the place. By the time Ketchum got the NYSE job, all was forgiven and forgotten. Pretty much nobody noticed that Ketchum had done such an outstanding job for the membership of the NASD. Pretty much nobody remembered about the floor brokers and the flipping and all that stuff.
In any case, the SEC has had a lot on its plate, issues of a great deal more importance than floor brokers breaking a few silly laws and the NYSE letting them do it. There is the ongoing controversy surrounding Wall Street analysts, for example, in which not a stone has been left unturned.
Well, maybe just one stone—actually, it’s more like a boulder.